The amazing yield conundrum

Today's investment climate is unique, if only in one respect: the huge difference between the current yield on cash and on alternative investments.

In a time when cash is yielding almost nothing, investors are faced with alternatives that are much more attractive. Equities, for example, are yielding 700 bps more than cash. Emerging market debt is yielding 650 bps more; high-yield debt almost 580 bps more; BAA corporate bonds 460 bps more; and investment grade corporate debt 320 bps more.

Despite the huge yield advantage to be gained from alternative investments, bank savings deposits—which yield almost nothing—have surged by almost 70% in the past 4 years (13% per year annualized), and are up from $4 trillion to almost $7 trillion.

This can only mean one thing: the market is extremely risk-averse. To pass up equity yields of 7% in favor of cash yields of practically zero, you have to believe that equities are extremely risky, and might well decline at least 6-7% a year for the foreseeable future.

This pessimism is even more pronounced when you consider that on average, the S&P 500 index has increased about 7% per year for the past 60 years. Not only is the earnings yield on the S&P 500 over 7%, the above chart argues that it's expected price appreciation is about 7% a year. The market is passing over a possible equity return of 14% per year in favor of cash that yields nothing.

And it's not just U.S. equities that the market is trying to avoid, it's equity markets the world over. As the chart above shows, the market cap of global equity markets has risen by almost $30 trillion (more than double) even as interest rates on safe-haven assets have plunged and holdings of risk-free assets have soared.

Indeed, one might say that higher equity prices have encouraged a flight to safety. How else to explain that as equity prices return to their pre-recession highs, risk-free yields are approaching historical lows?